CHAPTER ONE

1.1       BACKGROUND OF THE STUDY

Most business opportunities are not exploited in developing nations. Some, when started are abandoned as a result of lack of funds. The above scenario has had negative consequences on the growth of the economy. One of the major economic goals of Nigeria is satisfactory and sustainable economic growth (NEEDS, 2004). Economic growth depends in part on an efficient financial market. A financial market is efficient to the extent it brings about efficient allocation of resources including credit (Yaron, 1994).

Credit, based on sources and extent of government supervision, has been broadly classified into formal and informal (Aryeetey, 1997). The formal financial sources are those under the direct supervision of the Central Bank of Nigeria (CBN). They include commercial banks, rural banks, investment houses, insurance companies, and financing companies. These institutions have loan-able funds at their disposal. The volume of credit they give may likely meet the credit needs of borrowers who meet their lending conditions (Poyi, 2000; Mkpado and Arene, 2007). The formal institutions however have such problems as high transaction costs, low-level services to customers, long and tedious bureaucratic procedures, poor information about borrowers among other weaknesses (Atieno, 1994). On the other hand, informal financial institutions have acceptable credit programs, cheap outreach, enforcement mechanism, and good information about borrowers but they do not provide enough credit to borrowers.

Information is a major factor in resource allocation in the financial market. For instance, a lender’s willingness to lend may hinge on the information about the borrower. The absence of information may explain why lenders choose not to serve some individuals (Yaron, 1994).

Information   imperfections are important in explaining the segmentation of credit markets into formal and informal. Information flows are typically efficient over relatively close distances and within social groups, as found in the informal setting. This is one of the advantages the informal financial sector has over the formal financial sector (Bell, 1990).

The failure of formal financial institutions such as banks to serve poor borrowers is due to a combination of high risks, high costs, and consequently low returns associated with such businesses. To lower these risks, banks screen potential borrowers to establish the risk of default; they create incentives for borrowers to fulfill their promises to repay; and they develop various enforcement strategies to encourage repayment, to the extent of available information.  Scarcity of information results in information asymmetries between borrowers and lenders (Varghese, 2005).  In order to address this problem, banks often attach collateral requirements to loans. Unfortunately, conventional collateral requirements usually exclude poor borrowers, who seldom have sufficient forms of conventional title.

Informal lenders have often, innovatively succeeded in limiting loan default. For instance, by lending to Self Help Groups (SHGs), the joint liability and social collateral thus created ensure strict screening and monitoring of members (Mosley 1996; Nathan, 2004). From the foregoing, each financial institution has several strengths and weaknesses. There is no unique the financial institution that can provide adequate financial services to borrowers.

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